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The SEC’s Liquidity Proposal in Detail: Liquidity Risk Management Program

The SEC’s new liquidity proposal would require open-end funds (including open-end ETFs but excluding money market funds) to implement liquidity risk management programs in order to “reduce the risk that funds will be unable to timely meet their redemption obligations . . . , mitigate potential investor dilution, and provide for more effective liquidity risk management among funds.” The release defines liquidity risk as “the risk that a fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value.”

A fund’s liquidity risk management program would be required to include a classification of the liquidity of each fund holding, an assessment and review of the fund’s liquidity risk, establishment of a minimum amount of cash and highly liquid assets to aid in meeting redemption requests.

Fund boards would have specific responsibilities in connection with funds’ liquidity risk management programs.  Boards would be required to approve the written liquidity risk management program, as well as any material changes to it.  While a board would be permitted to rely on written summaries of the program, “[t]he summaries should familiarize directors with the salient features of the program and provide them with an understanding of how the liquidity risk management program addresses the required assessment of the fund’s liquidity risk, including how the fund’s investment adviser or officers administering the program determined the fund’s three-day liquid asset minimum.”  In addition, directors also would have to approve the fund’s designation of those responsible for administering the program (who cannot be “solely portfolio managers”). Those designated with administering the program would be required to provide the board a written report on the adequacy and effectiveness of the program at least annually.

The proposal would require a fund to classify the liquidity of each of its positions (or portions of a position) into one of six “buckets” based on the number of days it would take the fund to convert the position to cash “at a price that does not materially affect the value of that asset immediately prior to sale.” The proposed rule would also require a fund to conduct an “ongoing review” of the liquidity classifications. Though the rule does not specify a frequency, it suggests in certain instances where liquidity depends significantly on market conditions, funds may want to conduct the review “up to daily, or even hourly, depending on facts and circumstances.” The classification of each holding would be added to the proposed N-PORT forms that a fund would file with the Commission monthly.

Funds would be required to consider the following in classifying an asset:

  • Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants;

  • Frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange);

  • Volatility of trading prices for the asset;

  • Bid-ask spreads for the asset;

  • Whether the asset has a relatively standardized and simple structure;

  • For fixed income securities, maturity and date of issue;

  • Restrictions on trading of the asset and limitations on transfer of the asset;

  • The size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and

  • Relationship of the asset to another portfolio asset.

The proposal would also require a fund to assess and periodically review its liquidity risk, although the SEC did not specify a particular interval for the review. To assess risk under the proposal, each fund would be required to consider the following factors:

  • Short-term and long-term cash flow projections, taking into account the following considerations:

    • Size, frequency, and volatility of historical purchases and redemptions of fund shares during normal and stressed periods;

    • The fund’s redemption policies;

    • The fund’s shareholder ownership concentration;

    • The fund’s distribution channels; and

    • The degree of certainty associated with the fund’s short-term and long-term cash flow projections

  • The fund’s investment strategy and liquidity of portfolio assets;

  • Use of borrowings and derivatives for investment purposes; and

  • Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.

The proposal would require a fund to manage liquidity risk, by requiring funds to establish a three-day liquid asset minimum and codifying SEC staff guidance allowing a fund to hold no more than  fifteen percent of its assets in  illiquid securities. Subject to board approval, the fund, after considering the liquidity risk factors above, would need to set a “three-day liquid asset minimum,” or the “minimum portion of net assets in cash and assets that the fund believes are convertible to cash within three business days without materially affecting the value of the asset.” The proposal is intended “to increase the likelihood that the fund will hold adequate liquid assets to meet redemption requests without materially affecting the fund’s NAV.” While a fund would not be required to sell portfolio securities to meet the three-day liquid asset minimum, the fund would only be able to acquire three-day liquid assets until it again reaches its three-day minimum.  The rule also would require a fund to review the set minimum no less frequently than semi-annually.

The proposal states that board approval of the three-day liquid asset minimum would provide “independent oversight over funds’ liquidity risk management.”  In approving the three-day asset minimum, the SEC stated that it would “expect that a board approving a fund’s three-day liquid asset minimum would consider how the specified factors inform that minimum, and thus we believe that the proposed rule would cause fund boards to consider a comprehensive set of issues surrounding the fund’s liquidity risk and risk management.”

The proposal would codify the SEC staff’s longstanding guideline that a fund should generally limit to fifteen percent the amount of illiquid assets in its portfolio, defined as those assets that cannot be sold within seven days at approximately the value that the fund has assigned to the holding. However, unlike the three-day liquid asset definition, “a fund would not be required to take into account the size of the fund’s position in the asset or the time period associated with receipt of proceeds of sale or disposition of the asset” when assessing fifteen percent standard assets. The proposal would restrict a fund from acquitting a new asset in that category if the fund were already over the fifteen percent limit.

The release acknowledges that the use of redemptions-in-kind may allow a fund to manage liquidity risk, but suggests that many funds would only consider its use in emergency situations and do not have policies and procedures to govern its use. The proposal would require funds that allow in-kind redemptions or that reserve the right to engage in the practice to implement policies and procedures governing its use. The release suggests that having policies and procedures “would increase the likelihood that in-kind redemptions would be a feasible risk management tool.”

Lastly, the release requests comment on whether the SEC should propose rules allowing a fund to suspend redemptions and postpone payment of redemption proceeds so that the fund could conduct an orderly liquidation or in certain emergency situations such as when there has been a high level of redemptions over a period of time or in times of market volatility.